Real estate is a dynamic asset. It can produce passive income. With enough work, it can produce even more income.
Hotels are an example. They are fundamentally a rental operation; however, the most successful hotels make more off of the related services than they do from their rental income. A successful hotel can be viewed as a number of distinct businesses and activities–including everything from a restaurant, convenience store, bar, etc. These related businesses are more active, rather than passive.
Our tax laws recognize this unique aspect of real estate. The Passive Activity Loss rules were written so that losses from the passive collection of rents are limited, but losses from more active real estate activities are not.
In drafting these rules, Congress had to draw lines. There were winners and losers in this process. One winner is real estate agents. Real estate agents qualify for an exception that allows them to sidestep the Passive Activity Loss rules. This does not mean that the IRS will not challenge this favored status. It frequently does just that. The recent Agarwal v. Commissioner, T.C. Summary Opinion 2009-29 provides an example. The case is a must-read for anyone in a real estate-related business who owns loss-producing rental properties.
Facts & Procedural History
This case concerned the taxpayer-wife’s job. She was licensed as a real estate agent. She was employed as a realtor by Century 21. As are most realtors, she was paid as an independent contractor.
The taxpayers also owned two rental properties. The taxpayer-wife managed the properties.
In 2001 and 2002, the taxpayer-wife reported approx. $13K of income from selling homes. She also reported that much in expenses. This resulted in a small loss each year.
The taxpayers reported a $20K and $40K loss in these years for their rental properties. The losses were deducted on their tax returns and the losses offset the taxpayer-husband’s employee wages.
The IRS audited their tax returns and disallowed the losses. It did so by asserting that the passive activity loss rules (“PAL rules”) applied. According to the IRS, the taxpayer-wife did not qualify for the “real estate professional” exception to the PAL rules. The taxpayers eventually litigated the case in the U.S. Tax Court.
This case presents the very fundamental question as to whether a realtor who has minimal income, and perhaps minimal work activity as a relator, can qualify as a real estate professional.
About the Passive Activity Loss Rules
The PAL rules were enacted in the late 1980s to limit the ability of taxpayers to use rental real estate to reduce income taxes. If you were around in the 1980s and remember those days, you will recall that the tax rates were extraordinarily high in the 1980s. Those with higher incomes had a strong incentive to find ways to lower their tax burden. Many turned to real estate given the ability to generate tax losses.
They did so by borrowing money and buying real estate using other people’s money. This allowed investors to obtain a sizable amount of real estate with little money down–and to do so while maintaining the investor’s full-time day job. From a tax perspective, this entitled investors to significant depreciation deductions, interest deductions, etc. that could offset their wages. This is what the PAL rules were intended to limit.
The PAL rules are nuanced, but not all that difficult to plan for and avoid. One way to avoid the rules is to qualify as a “real estate professional.”
The Real Estate Professional Exception
The real estate professional exception is set out in the tax code. It essentially treats rental real estate as any other trade or business in which the taxpayer materially participates. These real estate businesses are able to generate tax deductions that can offset other items of income, such as employee wages.
To qualify, the taxpayer generally has to show that they spend at least half of their working hours on real estate and more than 750 hours in real estate each year. For the hours that are counted, the hours spent in certain real estate-related professions can count. These businesses are referred to as a “real property trade or business.”
The Code defines a “real property trade or business” as:
any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
If the taxpayer’s non-rental activities fall into these categories, then the hours spent on these activities can be counted in determining whether the taxpayer spent half of their time in real estate and whether it was more than 750 hours during the year.
This allows many taxpayers to qualify as real estate professionals and, thereby, deduct rental property losses against their other business income.
Is a Realtor a Real Estate Professional?
That brings us to the Agarwal case. In Agarwal, the IRS argued that the taxpayer-wife was a real estate agent, not a real estate broker.
As set out in the quote above, the “real property trade or business” language only includes brokerage businesses. It does not list real estate agents as qualifying. This was the IRS’s argument. It argued that absent a broker’s license, the taxpayer-wife could not be a real estate professional.
The court did not agree with the IRS. The court did not look at the state licensing rules. Rather, the court looked to the ordinary definition of the term “real estate brokerage” as it is commonly understood. This definition includes real estate sales. Based on this, the court concluded that the taxpayer-wife is a real estate professional. The court allowed the taxpayers to offset the taxpayer-husband’s wages with the losses from their rental properties.
Tax Planning for Real Estate Professionals
This case makes it clear that real estate agents qualify as real estate professionals. If they own rental real estate, they will almost always be able to use the losses from the rental properties to offset their income.
While not addressed in the case, there is an exception for employee wages. Employee wages in these businesses do not count unless the taxpayer owns 5 percent or more of the business. For example, if the taxpayer-wife worked as an employee of a real estate property management business, her wages from the property management business could not be counted. The wages could be counted if she owned more than 5% of the property management business.
It should also be noted that taxpayers may be required to group their rental and non-rental activities by making an election to do so. The grouping rules create other complexities that have to be considered, which warrants talking with an experienced tax attorney.
The Agarwal case confirms that real estate agents can qualify as real estate professionals and use losses from rental properties to offset their income, even without a broker’s license. This is important for tax planning for those in real estate-related businesses who own loss-producing rental properties. However, there are exceptions and complexities to consider, such as grouping rules and the 5% ownership requirement for employee wages. Consulting with an experienced tax attorney is recommended.